Euro Survives, but Future Is in Doubt

Only a few months ago, it was front-page news. Would the euro collapse? Would most of southern Europe go broke, unable to borrow money at any reasonable rate? Would that bring on a new world recession?

But in this week’s foreign policy debate between President Obama and Mitt Romney, the euro never came up. Europe was mentioned once, but the reference had nothing to do with economics. Mr. Romney did refer to Greece, but only to say we were in danger of going down the same path if we did not change our ways.

To a surprising extent, the perception seems to be that the European situation is under control. That is true if all you worry about is whether bondholders will get paid. It is false if you have a broader perspective.

The focus of the last couple of years on borrowing costs for peripheral members of the euro zone was, in retrospect, unfortunate. It was always clear that Europe, as a whole, had the ability to solve that issue if it wished to do so. The European Central Bank, like the United States Federal Reserve, has the ability to print money, and that is what it finally did.

“The actions of the E.C.B. and other policy makers in Europe have generally had the effect of filling large financial gaps in periphery bank and sovereign funding,” wrote Bob Prince of Bridgewater Associates this week, “but have done relatively little to resolve competitive imbalances among these economies.”

Banks are hesitant to lend. On Thursday, the European Central Bank report on loan activity in September showed a record 1.4 percent year-over-year decline in loans outstanding to private sector companies and individuals in the euro zone. “These numbers are rather consistent with the bleak picture painted by business surveys, showing an ongoing contraction of activity,” wrote François Cabau and Phillippe Gudin of Barclays Capital in a note to clients.

If peripheral countries simply had fixed exchange rates, rather than a common currency, they could and almost certainly would have devalued their currencies long before now. That is the normal prescription for countries in financial distress. Couple it with austerity and revivals can be surprisingly rapid, as exports surge and imports plunge.

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Richard Lambert, a former central banker, said the European Union “has the capacity to get its affairs into order.”Credit
Peter Klaunzer/Keystone, via Associated Press

As it is, the process is sure to be long and painful, but not certain to succeed.

As Europe stumbles and slows, there has been a temptation in the United States to turn our attention elsewhere, to Asia for economic reasons and to the Mideast for political ones. Mr. Romney has tried to add South America to that mix. But neither the Romney nor Obama campaign has wanted to talk much about Europe, a fact that has been noted with a little alarm in Europe.

Richard Lambert, the chancellor of Britain’s Warwick University — and a former editor of The Financial Times as well as a former central banker — was in New York this week trying to convince Americans that they should care, and predicting that the euro will survive.

“The European Union has the capacity to get its affairs into order, if it has the political determination to do so,” he said in a speech at New York University. “This is a crisis about economic imbalances within the euro zone, more than it is about fault lines with the rest of the world.”

That is a point worth remembering. The euro zone as a whole is running smaller budget and current account deficits than is the United States. If it were one country, there might be articles about depressed regions, but not talk of collapse.

But it is not one country. It is taking halting steps in that direction, with a move to unified bank supervision, but political union is not going to happen; Angela Merkel’s name is never going to be on a ballot outside of Germany. Nor is there going to be easy labor mobility around Europe, even though that is supposedly guaranteed now. Cultural and language differences assure that.

Within the United States, there have long been depressed areas — sometimes changing, as when Texas went from boom to bust when oil prices collapsed in the early 1980s — and transfer of payments from one region to another. Europe does not have automatic transfer payments, but its various central bank programs, as well as the bailouts, amount to transfer payments from the rich countries to the poor ones.

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It was not easy getting the Germans to agree to those programs, and ambiguity remains regarding future transfers as a way of persuading depressed countries to stick to the austerity programs Europe demands. It was critically important that Ms. Merkel, Germany’s chancellor, was willing to approve the newest European Central Bank program despite the objections of Germany’s own central bank, the Bundesbank.

Ireland is often painted as the periphery’s success story, and in some ways it has been. Unit labor costs are down, and the country seems to be better able to compete in world markets. It did so with deflation, by slashing wages in the private and public sector, reducing unemployment benefits and raising the retirement age. Its exports are rising and — unusual for the periphery — its imports are also going up.

Those sacrifices amounted to a very large price to pay for the sin of having a housing bubble that devastated the country’s banks, and then its government when it tried to stand behind the banks.

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One reason that Americans have been dubious about the prospects for euro survival is that it is hard for us to imagine anyone accepting such a prescription when simply adopting a (quickly devalued) new currency would seem to be much less painful, even considering the financial chaos that might ensue for a brief time.

The wealth of the populace, measured in foreign currency, would decline, but nominal salaries would not. Fixed payments — such as car payments and mortgage payments — would not suddenly increase as a percentage of income, as they have with slashes in paychecks.

But the euro never was primarily an economic creation. The political reasons for binding Europe together were — and are — more important. “It is essential to understand the strength of the political glue that is holding the project together,” Mr. Lambert of Warwick University said in his speech. “A whole generation of political leaders want this project to survive, and they have the economic resources to make it do so if they choose to use them.”

He pointed out that polls in Greece — which seems to be in a never-ending depression — still show strong support for the euro, and so do polls in Finland, which has been upset over the need to support the periphery.

If countries in the periphery cannot devalue their currencies versus the German currency — that is, if they stay in the euro — then they must somehow get their labor costs in line with Germany’s. There is talk of, and even some action, regarding labor market reforms, but that is a slow process.

In Portugal, the clever idea was something called “fiscal devaluation,” in which taxes were to be adjusted to lower labor costs. The government proposed charging lower payroll taxes to companies and higher ones to workers. That would have cut take-home pay, and reduced wage costs for business. The populace was outraged, and the government backed down.

It is not only the troubled countries on the periphery that saw inflation, and unit labor costs, rise much faster than costs in Germany over the past decade, leading to the competitive problem. That is still true in Italy and France. Mr. Lambert argues that the most important issue facing Europe is whether France will get a handle on its competitiveness problem.

German inflation would help greatly, and that could be a side benefit of the central bank running its printing presses full out.

In the long run, the peripheral economies must become competitive with their neighbors, so they can earn their own way, or the result will be, in Mr. Lambert’s words, “the permanent division of Europe into creditor and debtor nations, with the creditors dictating the terms.” That, he says, “would not be politically sustainable over time.”

The euro zone is not about to collapse. Whether it can be sustained over the long term is not as clear.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

A version of this article appears in print on October 26, 2012, on Page B1 of the New York edition with the headline: Euro Survives, But Future Is in Doubt. Order Reprints|Today's Paper|Subscribe